Bond Investors Stuck With Paltry Yields, Growing Risk – Wells Fargo

By Michael Aneiro

Wells Fargo Private Bank takes a look at the bond market’s sustained strong performance this year and says we’re getting to a point where bad things are going to happen to investors one way or another, either through price losses as rates rise or through paltry yields if rates hold steady. George Rusnak, Wells’s national director of fixed income, and Peter Wilson, international fixed income strategist, say the main thing holding U.S. bond yields down right now, at a time when they’ve been expected to rise, is their relationship with European bond yields, as the European Central Bank has one-upped the Fed with its easy monetary policy:

10-year U.S. Treasury yields compare very well to yields of the perceived safety of “core” Eurozone Government bond markets, from German Bunds and French OATs to Belgian OLOs. The difference between 10-year German Bunds and 10-year Treasuries has widened to 120 basis points, virtually a 25-year high, so further falls in German yields tend to drag Treasury rates lower too. Even within the lower-credit, “peripheral” bond markets, such as Spain and Italy, yields have converged with those of U.S. Treasuries to such an extent that public and private international investors consider Treasuries particularly attractive on a risk-adjusted basis.

Rusnak and Wilson still expect the 10-year Treasury yield (currently at 2.52%) to rise to 3.25% by the end of the year, setting up a dilemma for bond investors:

[T]he latest bond rally has created an asymmetric risk profile for the domestic fixed income asset class. That is to say, if yields rise towards our 3.25 percent target, then Treasury bond returns will be low, if not negative. But even if this target is not attained, yields are already too low for returns to be attractive, whether the market stays range bound or if the rally can be extended a little further. In this context, the risk/return trade-off is unattractive and better opportunities may exist elsewhere.

As for what investors can do, Wells seems to say they’d be better off looking for something other than bonds, or at least recognizing that it’s time to play defense:

Investors who are still overweight fixed income can use these higher bond prices to rebalance towards neutral weightings. Within the asset class, exposure to lower-yielding U.S. Treasuries should be a limited part of a diversified fixed income portfolio, used to mitigate risk from any one component—including investment-grade corporate credit and, in appropriate size, high-yield bonds.

Potential interest-rate risk and credit risk can be lowered within the asset class by reducing longer-maturity bond exposure and trimming weaker credits from the corporate or municipal bond exposure. Any reduction in portfolio yield that this will entail is the price of a more defensive position that will help protect returns when yields rise and credit spreads widen.